How many funds do you need for adequate diversification?

You would have come across a number of articles in the media by financial experts recommending diversification in your investment portfolio. Perhaps your own financial advisor would also often be advocating this. By diversification, they mean that your investments need to be spread across more than one stock / asset / fund etc. This is with a view to minimize the risk of your portfolio falling in value if things were to go wrong with a large or a few large investments forming part of your portfolio. To be specific, let’s say a large amount of your money is invested in only one company’s stock and recently, price of that stock has been on a continuous decline… you would end up bearing a significant loss. As against this, if you had some amount invested in say, a bank deposit or a company bond, there were chances that some amount of the wealth could have been preserved. So spreading your money among the stocks of different companies or between different asset classes minimizes risk, even if it does not totally eliminate it. The same is true for most of your other investments too, except mutual funds. Here’s how...

Diversification in mutual funds

The principle of diversification applies to mutual funds too though in a slightly different way. Remember, all mutual fund schemes by design provide you a diversified portfolio by spreading your money among multiple securities thus minimizing the impact of failure / underperformance of one security. Does this mean that you can put all your money in just one mutual fund scheme? Not really. Having more than one fund helps you:

a) Benefit from different investment strategies and ideas. Each fund category comes with its own differentiated approach to earning returns.

b) Participate in the outperformance of different segments of the equity and debt market at different points of time.

c) Minimize the risk to your portfolio due to any adverse development in one section of the financial market.

Hence, diversification is applicable to mutual fund schemes too.

Then, is more the merrier?

Does diversification mean that you populate your portfolio with dozens of schemes? Well, not exactly. Remember, diversification beyond a point proves counter-productive. Having too many funds in your portfolio results in:

Unwieldy portfolio: You will have to monitor too many schemes and keep track of their performance. This defeats the very purpose of seeking mutual funds for your investment because this will take up a lot of your time and effort.

More transactions: Investing in too many schemes will multiply your number of transactions with the resultant increase in costs and taxes. If you were to buy dozens of schemes either in lump sum or through Systematic Investment Plans (SIP), you would find it difficult to manage your investments in terms of paperwork and keeping track of dividends, investments and redemptions.

Duplication: You could end up having many funds with a more or less similar portfolio which is not what you would expect in diversification. For example, if you have ten funds that invest in large caps, there is a high possibility that those schemes will have 50% to 60% of their portfolio in the same stocks / sectors.

So how many funds do you really need to diversify adequately?

Well, there is no magic number that can answer the question. More than the quantity, quality of diversification would matter. There is no point in having five funds,all with the same / similar investment approach. This is not going to give you the real diversification that you are looking for. So diversification would need to be done across:

Asset classes: It is prudent to spread your money among various assets like equity, debt and gold. This ensures that you participate in the out performance of these assets which usually happens at different points in time.

Market capitalizations: Putting all your money in many schemes, all operating in the same market cap too is not optimal. You would need a blend of large, medium and small cap funds to build a good portfolio due to the varied risk and return characteristics that each of them exhibit.

Investment styles and strategy: There are many investment styles like growth investing, value investing, dividend yield strategy, special situations strategy etc. A good portfolio will have a blend of these styles.

Geographies: You would also do well to spread your money in more than one country. This is to safeguard against geo-political events and currency risks. Every country has its own strengths and weaknesses and geographical diversification ensures that you get the opportunity to participate in the other growing economies, also thereby reducing country-specific risk.

Sectors and Themes: If your risk appetite permits, one should also allocate a small amount of the total portfolio (may be 5 or 10%) to sectors and themes which would do well in the time to come. However, this should not form part of the core allocation of your portfolio.

In a nut shell: Diversification is a must for mutual fund schemes too. The focus should be on the quality rather than the quantity of diversification. Constituents of the portfolio must complement each other in minimizing risk and generating returns.